Chapter 4
THE CIRCULAR FLOW
4.1 THE EXPANDED CIRCULAR
FLOW MODEL
4.2 GOVERNMENT,FINACIAL MARKETS
AND INTERNATIONAL MARKETS
4.2.1 Government
the provision of law and order services;
the provision of goods and other services;
improving equity in the distribution of income;
influencing the general economic climate.
4.2.2 Financial markets
Meaning
Financial institutions through which savers can directly provide
funds to borrowers.
Borrowers – demanders of finance
households,firms and governments that choose to spend more
than they earn in income or collect in revenue at some point in
time.
Savers – suppliers of finance
households,firms and government that choose to spend less
than they earn in income or raise in revenue at some point in
time.
Saving
part of income or revenue that is not spent at some point in time,
or the postpone spending until some time in the future.
1,The Bond Market
Bond
a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond,
(IOU)
Attributes
term,the length of time until the bond matures
credit risk,the probability that the borrower will fail to
pay some of the interest or principal,(default)
tax treatment,the way in which the tax laws treat the
interest earned on the bond.
2,The Stock Market
Stock
a claim to partial ownership in a firm
equity finance vs debt finance
stock exchange,e.g,New York Stock Exchange,the
American Stock Exchange,NASDAQ (National
Association of Securities Dealers Automated
Quotation system)
prices are determined by the supply and demand for
the stock in these companies.
stock index,an average of a group of stock prices
3,Bank
Financial intermediaries
financial institutions through which savers can
indirectly provide funds to borrowers
Bank’s primary job
to take in deposits from people who want to
save and use these deposits to make loans to
people who want to borrow.
4.2.3 International market
Export
the factors and products that supply to
overseas markets
Import
the factors and products that demand from
overseas
Current account balance
deficit,import > export
surplus,import < export
4.3 Measuring the size of the economy
4.3.1 GDP (Gross Domestic Product)
the market value of all final goods and services
produced within a country in a given period of time
final versus intermediate
it can be measured by adding up
all expenditures on final output of firms
all the incomes generated by production of final output
all value added in production
Classification
nominal or current GDP
Values of GDP that have not been adjusted for price changes
real or constant GDP
Values of GDP that have been adjusted for price changes
Deflator
the price level expressed as a decimal fraction of the original
price level
4.3.2 Other measure of income
Gross national product (GNP)
Net national product (NNP)
National income
Personal income
Disposable personal income
4.3.3 The Components of GDP
GDP(E) = C+I+G+X-M
C- Consumption
spending by households on goods and services,with the
exception of purchases of new housing
I- Investment
spending on capital equipment,inventories,and structures,
including household purchases of new housing
G- Government purchase
spending on goods and services by local,state,and federal
government
X- Export expenditure
spending on domestically produced goods by foreigners
M- Import expenditure
spending on foreign goods by domestic residents
4.4 EQUILIBRIUM IN THE
CIRCULAR FLOW MODEL
Flows out of the circular flow
(withdraw)
saving by households
saving by firms
taxes paid by household to
government
taxes paid by firms to
government
imports of factors of
production
imports of goods and
services
Flows into the circular flow
(injection)
borrowing by households
borrowing by firms
transfers paid by governments
to households
transfers paid by governments
to firms
government purchases of
factors of production
government purchases of
goods and services
exports of factors of
production
exports of goods and services
S+T+M=B+F+G+X
(B-S)+(F+G-T)+(X-M)=0
S- saving by households and firms
T- total tax payment by household and firms
M- total imports of factors and products
B- total borrowing by household,firms and
governments
F- total transfer payments by government (social
security and welfare)
G- total purchase by government
X- total exports of factors and products
4.5 ECONOMIC INDICATORS (1)
Inflation
percentage increase in the average price level over
some period of time in an economy.
Unemployment
percentage of people in the economy who would work
at the existing wage,but cannot find work
Economic growth
measured by the percentage change in gross
domestic product over some period of time after
making an adjustment for inflation.
4.5 ECONOMIC INDICATORS (2)
Balance of payments
measured by the difference between export
income and import expenditure.
Sustainability
in economy,it uses all the factors of
production that it has in such a way that the
degree to which needs and wants can be met
will be sustained for future generations.
Economic Growth
Productivity
the amount of goods and services produced from each hour of a
worker’s time.
Determinants
physical capital
the stock of equipment and structures that are used to produce goods and
services
human capital
the knowledge and skills that workers acquire though education,training,
and experience
natural resources
the input into the production of goods and services that are provided by
nature,such as land,rivers,and mineral deposits.
technological knowledge
society’s understanding of the best ways to produce goods and services.
Production Function
Y = AF (L,K,H,N)
Balance of Payments (1)
Trade balance = Income by exporting products - Expenditure by
importing products
Net investment
income from
overseas
= Income by exporting factors of
production
- Expenditure by
importing factors of
production
interest on loans,rent on real estate,dividends on shares
Net transfer
received from
overseas
= Transfers received from
overseas
- Transfers paid
overseas
remittances by foreign workers + transfers of assets by
migrants and foreign aid payments
Balance of Payments (2)
Current
account
balance
= Trade
balance
+ Net investment
income from
overseas
+ Net transfer received
from overseas
Net capital
flow from
overseas
= (total lending overseas
+ buying foreign-owned
assets)
- (total borrowing overseas
+ selling domestically
owned assets)
Balance of
payment
= Current account
balance
+ Net capital flows
from overseas
+ Statistical
discrepancy
THE CIRCULAR FLOW
4.1 THE EXPANDED CIRCULAR
FLOW MODEL
4.2 GOVERNMENT,FINACIAL MARKETS
AND INTERNATIONAL MARKETS
4.2.1 Government
the provision of law and order services;
the provision of goods and other services;
improving equity in the distribution of income;
influencing the general economic climate.
4.2.2 Financial markets
Meaning
Financial institutions through which savers can directly provide
funds to borrowers.
Borrowers – demanders of finance
households,firms and governments that choose to spend more
than they earn in income or collect in revenue at some point in
time.
Savers – suppliers of finance
households,firms and government that choose to spend less
than they earn in income or raise in revenue at some point in
time.
Saving
part of income or revenue that is not spent at some point in time,
or the postpone spending until some time in the future.
1,The Bond Market
Bond
a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond,
(IOU)
Attributes
term,the length of time until the bond matures
credit risk,the probability that the borrower will fail to
pay some of the interest or principal,(default)
tax treatment,the way in which the tax laws treat the
interest earned on the bond.
2,The Stock Market
Stock
a claim to partial ownership in a firm
equity finance vs debt finance
stock exchange,e.g,New York Stock Exchange,the
American Stock Exchange,NASDAQ (National
Association of Securities Dealers Automated
Quotation system)
prices are determined by the supply and demand for
the stock in these companies.
stock index,an average of a group of stock prices
3,Bank
Financial intermediaries
financial institutions through which savers can
indirectly provide funds to borrowers
Bank’s primary job
to take in deposits from people who want to
save and use these deposits to make loans to
people who want to borrow.
4.2.3 International market
Export
the factors and products that supply to
overseas markets
Import
the factors and products that demand from
overseas
Current account balance
deficit,import > export
surplus,import < export
4.3 Measuring the size of the economy
4.3.1 GDP (Gross Domestic Product)
the market value of all final goods and services
produced within a country in a given period of time
final versus intermediate
it can be measured by adding up
all expenditures on final output of firms
all the incomes generated by production of final output
all value added in production
Classification
nominal or current GDP
Values of GDP that have not been adjusted for price changes
real or constant GDP
Values of GDP that have been adjusted for price changes
Deflator
the price level expressed as a decimal fraction of the original
price level
4.3.2 Other measure of income
Gross national product (GNP)
Net national product (NNP)
National income
Personal income
Disposable personal income
4.3.3 The Components of GDP
GDP(E) = C+I+G+X-M
C- Consumption
spending by households on goods and services,with the
exception of purchases of new housing
I- Investment
spending on capital equipment,inventories,and structures,
including household purchases of new housing
G- Government purchase
spending on goods and services by local,state,and federal
government
X- Export expenditure
spending on domestically produced goods by foreigners
M- Import expenditure
spending on foreign goods by domestic residents
4.4 EQUILIBRIUM IN THE
CIRCULAR FLOW MODEL
Flows out of the circular flow
(withdraw)
saving by households
saving by firms
taxes paid by household to
government
taxes paid by firms to
government
imports of factors of
production
imports of goods and
services
Flows into the circular flow
(injection)
borrowing by households
borrowing by firms
transfers paid by governments
to households
transfers paid by governments
to firms
government purchases of
factors of production
government purchases of
goods and services
exports of factors of
production
exports of goods and services
S+T+M=B+F+G+X
(B-S)+(F+G-T)+(X-M)=0
S- saving by households and firms
T- total tax payment by household and firms
M- total imports of factors and products
B- total borrowing by household,firms and
governments
F- total transfer payments by government (social
security and welfare)
G- total purchase by government
X- total exports of factors and products
4.5 ECONOMIC INDICATORS (1)
Inflation
percentage increase in the average price level over
some period of time in an economy.
Unemployment
percentage of people in the economy who would work
at the existing wage,but cannot find work
Economic growth
measured by the percentage change in gross
domestic product over some period of time after
making an adjustment for inflation.
4.5 ECONOMIC INDICATORS (2)
Balance of payments
measured by the difference between export
income and import expenditure.
Sustainability
in economy,it uses all the factors of
production that it has in such a way that the
degree to which needs and wants can be met
will be sustained for future generations.
Economic Growth
Productivity
the amount of goods and services produced from each hour of a
worker’s time.
Determinants
physical capital
the stock of equipment and structures that are used to produce goods and
services
human capital
the knowledge and skills that workers acquire though education,training,
and experience
natural resources
the input into the production of goods and services that are provided by
nature,such as land,rivers,and mineral deposits.
technological knowledge
society’s understanding of the best ways to produce goods and services.
Production Function
Y = AF (L,K,H,N)
Balance of Payments (1)
Trade balance = Income by exporting products - Expenditure by
importing products
Net investment
income from
overseas
= Income by exporting factors of
production
- Expenditure by
importing factors of
production
interest on loans,rent on real estate,dividends on shares
Net transfer
received from
overseas
= Transfers received from
overseas
- Transfers paid
overseas
remittances by foreign workers + transfers of assets by
migrants and foreign aid payments
Balance of Payments (2)
Current
account
balance
= Trade
balance
+ Net investment
income from
overseas
+ Net transfer received
from overseas
Net capital
flow from
overseas
= (total lending overseas
+ buying foreign-owned
assets)
- (total borrowing overseas
+ selling domestically
owned assets)
Balance of
payment
= Current account
balance
+ Net capital flows
from overseas
+ Statistical
discrepancy
